How blended capital can help entrepreneurs make it through the missing middle

SAN FRANCISCO — Alloysius Attah started Farmerline, a social enterprise in Ghana that connects small scale farmers with information, services, and markets, with just $600 in prize money from a mobile app competition.

Since then, he has found that he needs to travel outside of Ghana to attract the capital he needs to scale up his operations. 

When Attah was selected for Echoing Green, an organization that provides seed stage funding and support to global social entrepreneurs, he gained vital access to a network of funders. Now that his company has expanded to 11 countries, and earned $1 million in revenue, he is working to raise $1.5 million to scale to more countries and reach more farmers. Attah finds himself in what is often described as the missing middle, in which entrepreneurs who are just beyond the seed stage lack the medium- to long-term financing they need to keep on growing.

“It feels like starting a business all over again because you are interacting with a different level of investors and funders who might require certain boxes for you to check before they can be able to give you the support that you need,” he told Devex.

When Attah took the stage before Silicon Valley investors at an investor showcase in 2016, he had a message for both investors and grantmakers. He asked for a $300,000 equity investment to scale Farmerline’s operations to 3 new countries in the next 3 years as well as a $500,000 impact investment grant to fund an impact assessment and to pilot new services. Attah is one of a growing number of social entrepreneurs pursuing hybrid financing models to seed, de-risk, and scale up their startup companies.

With a blended capital approach, entrepreneurs can combine grants and investments, filling the gap that exists between philanthropy and public funding and traditional investment. As Ashoka, another organization that invests in entrepreneurs, puts it: “It has become increasingly more apparent that there is a massive financing gap between strategic philanthropy and investment to scale innovative social ventures. The current financial gap is at the stage when money required is too big for foundations and philanthropists, and too small and too risky for institutional social investors. And it’s at a stage particularly important for social entrepreneurs in order for them scale up and become financially sustainable.” By unlocking private capital, public funders and philanthropists can address the problem: Institutional impact investors seeking market rate returns are not investing in the social enterprises serving the base of the pyramid that are not operating at scale they could be.

The missing middle

Too many high-potential startups in emerging markets hit roadblocks to scale because they are unable to access the right kind of financing, said Allie Burns, managing director at Village Capital, which tackles obstacles such as the lack of access to local sources of capital in its work to democratize entrepreneurship across the United States and around the world.

“While many investors recognize that there’s tremendous opportunity to build valuable companies — that also have tremendous impact — in emerging markets, many aren’t yet accepting that successfully financing these companies won’t look like the classic Silicon Valley venture capital model,” she told Devex via email, following the Global Entrepreneurship Summit in Hyderabad, India, where she was a panelist in the master class focused on the missing middle. “Instead, investors will need to work with other stakeholders — grantmakers, governments, etc. — to create new and flexible financing structures for companies sitting in the missing middle.”

Oftentimes, the missing middle is not just a funding gap, but rather a failure to grow the business as initially expected, or a consequence of stalled growth, said Venktesh Shukla, the managing director of Monta Vista Capital, who moderated the master class.

“When the company is focusing on social impact in addition to profit, it should seek out investors that specialize in investing in social impact companies. Traditional venture capital is not suited for such investment. For non social impact companies, there is a need to understand the real reason for stalled growth,” he said.

Entrepreneurs need to ask themselves whether they are in the middle due to lack of capital or due to other reasons, such as access to and retention of talent. If it is for other reasons, more capital is not going to solve the problem, and investors will be wary anyway, he continued. If it is due to lack of capital, then they need to find investors who have experience investing in that geography, or local angel investors, although that is where they often come up against a lack of risk capital they need to attract growth capital.

Entrepreneurs need to educate themselves on the type of capital that is best for their business, investors need to provide more flexible options, and while there are no one-size-fits-all solutions to finance emerging market startups, conversations that bring these two groups together allow them to identify some models that might work, Burns added.

What kind of capital?

At the Echoing Green summit, Attah talked about how entrepreneurs who start companies in Africa, but are not from the continent, often have a much easier time raising money than entrepreneurs like himself who are from the countries where they work.

He joined panelists in the blended capital session to discuss their fundraising challenges and successes — for example, most investor dollars are going into Kenya, and 72 percent of venture capital went to just three companies in 2015 and 2016, according to a report from Village Capital.

The panelists said the type of money matters, both when it comes to what an entrepreneur is allowed to do with that money, and what that money signals to others, and added that startups must strike a balance between the value that grant capital, and particularly unrestricted grants, can bring, with the risk that it could send that founders might not be ready for investment.

“Investors are taking a little bit of a shortcut that leads them to talk with people from similar networks, people who speak the same language, people who understand how to translate what they are doing into what they are looking for,” Raymond Guthrie, a senior partner at the Global Innovation Fund, said of one of the reasons he sees for the same African companies drawing investment. “We’re less focused on the instrument, and more focused on helping innovations get to scale.”

With grants and risk capital, the Global Innovation Fund invests in the development, testing, and scaling of innovations aimed at improving lives in developing countries. An example is its $2.5 million debt investment to support the expansion of Babban Gona, which helps Nigerian farmers transition from subsistence to commercial farming. One of of the reasons the Global Innovation Fund provided for its investment was the opportunity to unlock capital from development finance institutions.

Traditional investors are becoming more interested in pursuing opportunities at the base of the pyramid, but many of their funds have structures that require them to make equity investments, and often these return expectations are higher than what the market will bear, Guthrie said. Oftentimes emerging market entrepreneurs are earlier stage long term growth plays, versus more tech enabled, fast growth, low cost, potentially high revenue models, so there can often be a disconnect when it comes to return expectations. Donors and development finance institutions can help to build up the investment market in countries where these ecosystems are not fully developed, Guthrie said.

What works — and what doesn’t

Depending on the approach, bilateral and multilateral donors can help or hinder the development of the the social entrepreneurship scene in the countries where they work. In Myanmar the impact has been largely negative, said Henrich Dahm, an independent private sector development expert based in Yangon.

“They are setting the wrong incentives for entrepreneurship by project-based support and conditioned short-term grants,” he said. “They are using the wrong tools to support real entrepreneurship.”

Most donors don’t get what is needed to support entrepreneurship, he said, noting for example how they make it so time consuming and complicated that they only attract entrepreneurs who really need their money because they cannot raise funds from the private sector.

The donor supported projects that work well hire professional private sector companies, like venture capital firms, to manage money in a fund because they have the necessary tools to get money to the right entrepreneurs, he said. As an example, the International Finance Corporation at the World Bank Group backs private equity funds in emerging markets. By providing risk capital in markets where it is scarce, private equity and venture capital can play a critical role in global development, the group argues.

There is a generalization that entities deploying grants, including official development agencies or philanthropic institutions, have not traditionally hired for business acumen, and entities deploying risk capital have not traditionally invested on a thesis that positive impact will deliver financial returns. But there are exceptions to the rule, said Joan Larrea, the chief executive officer of Convergence, a platform that brings public and private investors together in blended finance deals, which uses public or philanthropic funding to increase private sector investments related to the United Nations Sustainable Development Goals in developing countries. She hopes that as these two sides come together to structure transactions, and support social entrepreneurs who raise blended capital, they will learn from each other, but she said it will not be easy for entrepreneurs to pull this off at an early stage.

“The entrepreneur is just getting used to the requirements of outside equity investors and lenders. You add concessional capital or a mission-driven grant to this entrepreneur’s plate, and they now have to chart a strategic course that responds to several disparate parties’ financial objectives, while meeting the new objective of delivering a nonfinancial, social or environmental, outcome. That is pretty complicated for someone trying to run a new business,” she said.

She mentioned Global Vision, which Convergence is supporting with a design funding grant, as an example of a company with a replicable blended capital strategy. It launched with the aim of building and scaling a network of surgical eye care centers, and is raising grants, equity, and debt at a holding company level, which it will deploy that funding into country specific vehicles as it launches its operations. The organization intends to raise $300 million over the next 10 years, with a range of different funders bringing their added value — grants support startup expenses and market adaptation, equity supports early operations and capital expenditures, and debt supports scale up, Larrea said.

Making the ask

Social entrepreneurs who travel to Santa Clara University to participate in the Global Social Benefit Institute at Miller Center for Social Entrepreneurship work with their mentors on their impact model, their business plan, and their financing.

“The mentors work with the entrepreneurs to say, let’s be honest: What is your impact, what type of investors would be interested in your stage, and what type of return could you provide?” said Steve White, who directs the mentor network for this accelerator program known for its emphasis on mentorship. “Then you get to the point where you can say we want grants or we want blended capital.”

Entrepreneurs pitching investors, as Miller Center entrepreneurs like Attah do at an annual investor showcase in Santa Clara, California, need to be able to specify the amount of money they need, the type of capital they require, how they will use those funds, and what the returns for the investor will be, he said.

They should start by asking themselves what type of impact they want to have: Is it improving lives, transforming lives, or saving lives? Typically, the numbers of people they need to reach in order to attract investment goes down as you move from improving lives to saving lives, White explained. Then they should consider the perspective of investors, whether they are truly impact first, whether they expect a financial return on their investment — as is the case with most banks and leasing companies and equity investors — or whether they fall somewhere in between.

The problem is that teams that are already spread thin must develop in-house expertise not only for equity structures and pitches, but also grant writing and loan applications, said Marsha Wulff, an investor who helped to set up LoftyInc Afropreneurs Fund, a new $25 million impact venture fund that is seed stage and tech based.

“Each funding method comes with its own set of personal introductions and relationship building, as well as its own set of financial reporting and follow up,” she said. “This additional breadth creates additional layers of complexity and distractions from day-to-day company capacity building and efficient operation management.”

Pooled investment vehicles can be useful to entrepreneurs by attracting types of capital ranging from the concessional to the commercial. Financial institutions can pull multiple sources of finance into their capital structure then use that flexibility to lend to multiple entrepreneurial ventures with more flexible terms. Structuring impact ventures this way opens the door to a more varied pool of funders, and it also enables more funding matches from development institutions, such as the Overseas Private Investment Corporation’s program for financial intermediaries.

“Instead of only seeking equity capital for our portfolio of impact ventures, we are also seeking grant and debt funding. Of course grant funding leaves more equity available for impact investors to share. Similarly, debt investments leave more equity for equity investors to share,” Wulff told Devex.

From grants to investment

Echoing Green has done research on how the social enterprises they support at an early stage go on to secure both philanthropic and investment capital to build their organizations. In one report, grantmakers share advice with social entrepreneurs and other donors. They explain that grantors interested in promoting social entrepreneurship, but not yet making impact investment, should consider how grant funding can help social entrepreneurs become investment ready.

“A fair number of grant-making organizations don’t realize they can make grants to for-profit companies, but it’s an important role to play if the company hasn’t yet developed an impact investment strategy,” said Tony Carr, president of Halloran Philanthropies, which supports interventions that promote well-being. “We have made grants and then investments into a number of for-profit social enterprises as they became investment-ready. For example, we loved a company producing fortified nutritious rice in Mali, but they weren’t ready for investment at the time. So we first made a grant, then a convertible loan, and soon hope to make an equity investment into their business.” 

While a growing number of donors and NGOs are experimenting with impact investing, the key for grantmakers considering making grants to for-profit social enterprises is to determine which of them really need that kind of support to grow their business.

Last year, Development Innovation Ventures, an initiative by the United States Agency for International Development to support entrepreneurs with breakthrough solutions to global challenges, stopped accepting applications.

Jehiel Oliver, the founder of the agricultural technology social enterprise Hello Tractor in Nigeria, and moderator of the Echoing Green panel on blended capital, was among those who expressed concerns about what the potential end of DIV might mean for entrepreneurs in emerging markets. “My guess is that many companies just won’t get funded without USAID money flowing into these markets,” he told Devex. “This will result in many companies, particularly those with a social mission, not existing beyond the conceptual stage.” Within more mature markets, exploratory capital is often provided by venture capitalists and angel investors, but that investor class is nascents within markets like Nigeria, Oliver added.

DIV supports organizations with phase one grants, for proof of concept, phase two grants, for testing and positioning, and phase three grants, for transitioning to scale. USAID support throughout the three stages helps these organizations to become commercial investor ready. There were concerns that the close of applications might signal the end of DIV, but USAID announced 18 new grantees in November, explaining that for every U.S. taxpayer dollar spent the donor agency generated $4 in outside funding from investors, lenders, and philanthropists.

When it comes to outside investments into emerging markets, philanthropic money presents challenges associated with scaling, but venture capital money forces unrealistic frameworks for companies may not fit the model of three years plus an exit companies, said Peter Roberts of Emory University’s business school.

“What we need are funds that work with traditional risk-return mindsets, but that are funded by philanthropic investors,” he said. “This way, market interventions can be disciplined by market-based thinking without having to punish entrepreneurs for the fact that their ecosystems do not yet know how to find and support them.”

Roberts explained that emerging markets needed many more small and medium enterprises, rather than a few unicorns, but because these companies do not register in national statistics or investor portfolios, they are ignored. He said there is a need for more and not fewer programs like DIV, because there can be no learning if someone is not willing to pay for that learning. And he added that the biggest gains will come from figuring out how to better align supply and demand for different types of capital so entrepreneurs can be funded in ways that suit their stage and their needs.

Read more Devex coverage on entrepreneurship.